Book Title: eTextbook: Financial Management: Theory and Practice Chapter 5. Bonds, Bond Valuation, and Interest Rates Mini Case

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Mini Case Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and co-

directors of the company’s pension fund management division. An important new client, the North-

Western Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the

mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have

asked you to help them by answering the following questions.

a. What are the key features of a bond?

b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or

less risky?

c. How does one determine the value of any asset whose value is based on expected future cash

flows?

d. How is the value of a bond determined? What is the value of a 10-year, $1,000 par value bond

with a 10% annual coupon if its required rate of return is 10%?

e. What would be the value of the bond described in Part d if, just after it had been

issued, the expected inflation rate rose by 3 percentage points, causing investors to require

a 13% return? Would we now have a discount or a premium bond?

What would happen to the bond’s value if inflation fell and declined to 7%? Would

we now have a premium or a discount bond?

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What would happen to the value of the 10-year bond over time if the required rate of

return remained at 13%? If it remained at 7%? (Hint: With a financial calculator, enter

PMT, I/YR, FV, and N, and then change N to see what happens to the PV as the bond

approaches maturity.)

f. What is the yield to maturity on a 10-year, 9% annual coupon, $1,000 par value bond

that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a

discount or at a premium tell you about the relationship between and the bond’s coupon

rate?

What are the total return, the current yield, and the capital gains yield for the discount

bond? (Assume the bond is held to maturity and the company does not default on the

bond.)

g. How does the equation for valuing a bond change if semiannual payments are made? Find the

value of a 10-year, semiannual payment, 10% coupon bond if the nominal .

h. Suppose a 10-year, 10% semiannual coupon bond with a par value of $1,000 is currently selling

for $1,135.90, producing a nominal yield to maturity of 8%. However, the bond can be called

after 5 years for a price of $1,050.

What is the bond’s nominal yield to call (YTC)?

If you bought this bond, do you think you would be more likely to earn the YTM or the

YTC? Why?

i. Write a general expression for the yield on any debt security and define these terms: real

risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity

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premium (LP), and maturity risk premium (MRP).

j. Define the real risk-free rate (r*). What security can be used as an estimate of r*? What is the

nominal risk-free rate What securities can be used as estimates of ?

k. Describe a way to estimate the inflation premium (IP) for a t-year bond.

l. What is a bond spread and how is it related to the default risk premium? How are bond ratings

related to default risk? What factors affect a company’s bond rating?

m. What is interest rate (or price) risk? Which bond has more interest rate risk: an annual payment

1-year bond or a 10-year bond? Why?

n. What is reinvestment rate risk? Which has more reinvestment rate risk: a 1-year bond or a 10-

year bond?

o. How are interest rate risk and reinvestment rate risk related to the maturity risk premium?

p. What is the term structure of interest rates? What is a yield curve?

q. Briefly describe bankruptcy law. If a firm were to default on its bonds, would the company be

liquidated immediately? Would the bondholders be assured of receiving all of their promised

payments?

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